Thursday, February 14, 2013

The Unwarranted "Unwarranted Pessimistic Signal"

St. Louis Fed President James Bullard gave a speech on February 14 called "U.S. Monetary Policy: Easier Than You Think It Is." He claims that Fed policy is easier now than it was in 2012, mainly due to the implementation of a "threshold rule." The rule is basically a promise that the Fed will not raise policy rates until the economy reaches certain pre-specified thresholds: 6.5% unemployment or 2.5% inflation. The Fed will wait to raise the federal funds rate target until unemployment drops below 6.5% or inflation exceeds 2.5%. Prior to implementing a threshold rule, the Committee offered date-contingent rather than state-contingent forward guidance, stating that the policy rate would likely remain near zero until mid-2015.

The previous announcement that the policy rate would remain near zero until mid-2015 created a "pessimism problem," Bullard explains, because "the date could be interpreted as a statement that the U.S. economy is likely to perform poorly until that time." Bullard views the thresholds as alleviating an "unwarranted pessimistic signal" created by the date-based rule.

The threshold rule is also called the Evans rule, after Chicago Fed President Charlie Evans, who advocated for it and announced it in November 2012. Evans notes that Narayana Kocherlakota, Eric Rosengren and Janet Yellen have all publicly advocated threshold rules. But Bullard's view of how the threshold view is supposed to work seems different than the explanation proffered by Evans, who said:

An important new aspect of current round of purchases was to tie its length to economic outcomes, rather than announcing a fixed amount of purchases over a predetermined period as we have done in the past... Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.

Whereas Evans views the threshold as a way to clarify policy goals and assure the market that accommodation will be sufficient to close the resource gap without raising fears of excessive inflation, Bullard focuses instead on the "unwarranted pessimistic signal" issue. The idea that monetary policy can send a "pessimistic signal" is neither new nor unique to eras of unconventional policy. It has long been noticed that announcements of policy rate changes have the opposite effect of what theory would predict on long term interest rates (Cook and Hahn 1989). A proposed explanation for this puzzle is based on asymmetric information between the Fed and the public. Easy monetary policy can have a counterproductive impact if it signals to market participants that future economic conditions are likely to be worse than they thought. But this is only possible if the Fed has some information that the market does not have.

In a 2000 paper, Christina and David Romer compare Federal Reserve and commercial forecasts and determine that the Fed does indeed have information about inflation and output that the markets do not, so the signalling mechanism is plausible. One effect of lowering the policy rate is to reveal some of the Fed's negative information about the future. But this does not entirely justify Bullard's claim that the Fed was sending a pessimistic signal by announcing that the policy rate would remain near zero until mid-2015.
This announcement could have revealed either positive or negative information about the future. Market participants may have actually been more pessimistic than the Fed originally, believing that the economy would stay bad until later than mid-2015, in which case this announcement would provide an "optimistic signal."

There is no reason to assume that the markets were originally more optimistic about when the economy would improve than the Fed. So we do not know whether the announcement about mid-2015 caused people to become more optimistic or more pessimistic. Naming it an "unwarranted pessimistic signal" is, well, unwarranted. Thus we can't say that introducing a threshold rule has made monetary policy easier by removing an unwarranted pessimistic signal. I still think the threshold rule may be a good idea, but the explanation offered by Evans makes more sense.

Thanks, Prof. Roth, for linking to that paper. It may be helpful for my current research, which broadly has to do with expectations formation and uncertainty. Another paper that you might be interested in on this topic is by Kris Nimark, "Man Bites Dog Business Cycles."